Tuesday, August 12, 2008

US and Japan: Similar economic problems?

So which way is the current US economic slump going, and what is needed to fix it? To get clues toward answers, ask the Japanese. This slump is in many ways similar to what happened in Japan 1992, a stagnation that continues to this day.

How did the Japanese mess start? A summary by Satya Gabriel: Investors in Japanese assets began to project what would prove to be unsustainable growth rates in exports and domestic demand into the foreseeable future, bidding up asset values to unrealistic levels…. Japanese banks joined in the speculative bubble by not only financing the overinvestment boom of manufacturers but also financing real estate projects that depended on the aforementioned rapid rates of output and market share growth to generate the incomes that would make these real estate ventures profitable. Bankers expected that economic growth would generate more demand for office space, keeping occupancy rates high and generating growing rental incomes. Everybody seemed to be expecting the same thing --- that somehow Japan would keep growing both domestic demand and exports until the world was awash in Japanese goods and there would be little room left for American or European or any other manufacturers but the Japanese. The domestic side of this calculus did not seem to take into account the rapid aging of the Japanese population and the impact such aging would have on domestic demand curves. As for export expectations, in order to satisfy the earnings growth that seemed built into market valuations of exporters would have required the complete capitulation of American and European (and, perhaps, other Asian) firms to the Japanese corporate behemoth.

The bursting of the speculative bubble had serious repercussions in the Japanese banking system. Banks in Japan used their holdings of stock and real estate as part of their overall capital base upon which they determined the size of their loan portfolio. As equity prices and real estate market values collapsed, so did the capital base of the banking system. The banks were forced to severely contract their lending. Hardest hit by this credit crunch were smaller, more aggressive firms that are often the catalyst for major technological and marketing innovations in an economy.

If supply exceeds demand and there is no reasonable expectation that demand will pick up then the boards of directors of firms will not approve productive investment. Lower interests rates won't solve this problem. After all, who would borrow at any positive real rate of interest in order to build new plant and buy new equipment to produce output that goes unsold? Negative expectations can become reinforcing.

Reductions in productive investment can drive aggregate demand lower and make a whole panoply of other economic agents feel more pessimistic. As wage laborers (who are also the vast majority of consumers) become more concerned about their future then they become less likely to spend and aggregate demand falls further. Cuts in interest rates may even have the perverse effect of convincing economic agents that the economy is worse than they thought and reinforce the negative behavior that drives the economy lower (thus proving their assessment was correct). The Bank of Japan did not seem to get the basic point that expectations about future prospects for the economy can override interest rate cuts in determining the impact of monetary policy --- this was a point that John Maynard Keynes had made abundantly clear in his General Theory of Employment, Interest, and Money. Keynes called this problem a "liquidity trap."

Another site adds: From 1997 to 1998, banks and consumers preferred holding cash to investments because banks tightened the monitoring of performance. Short of credit, many companies went bankrupt. The reduction of government spending and banking reforms led to deflation.

The Japanese government has hesitated to resort to market measures in this economic recession (e.g., letting ailing banks and ailing big companies “die” through bankruptcies, because this would create great social instability, which traditionally has been avoided through a total employment policy). Unemployment has reached a historic high, for sure, but letting more companies go bankrupt would lead to an even higher rate of unemployment. So the government has allowed some companies to go bankrupt while bailing out some others.

Didn't they already try fiscal stimulus? Why didn't it work? Adam Posen, in his US Congressional testimony on the mater: Fiscal policy works when it is tried. The problem is that the Japanese government and the Ministry of Finance have way overstated the amount of fiscal stimulus in which they actually engaged. In total, around 23 trillion yen (4.5% of a year's GDP) was injected into the economy from 1992-97, in contrast to claims of 65-75 trillion yen. The government actually took a total 2.0% out of the economy in tax rises and spending cuts over the same years, which meant that the total stimulus was really small compared to the growth shortfall. In September 1995, they did pass a package that was large (1.5% of GDP) and 60% of the size they claimed, and they did get strong growth in 1996.

A better way out of the problem seems to be the following proposals. From Satya Gabriel: The Japanese government needed to stimulate those areas of the Japanese economy that have the highest "value added" or the greatest percentage of relatively advanced technology as inputs and outputs. Rather than construction spending, the Japanese government might have gotten more "bang for their buck" by spending on improvements in the high technology infrastructure of schools, colleges, universities, and the governmental bureaucracy; spurring increased research and development spending within Japanese firms (and not just the keiretsu industrial firms); and, on significantly reducing the environmental problems in the country (which could have spill-over effects in technological development and a positive effect on the "psychological mood" of Japanese citizens, at the same time). But no less important than doing a better job of targeting fiscal stimulus, the Japanese government needs to improve the lives of the Japanese citizens, to restore their confidence in the future, and by this approach to encourage more consumer spending and portfolio investments in Japanese equities.

A very vocal and prolific critic of the Japan mess has been Japanese economist Kaneko Masaru. Kaneko wants to bolster the financing and functions of the large-scale systems within which actors confront and cope with risks of the marketplace and life in general (e.g. sickness and ageing). These reforms include the funding and administration of pensions, inter-governmental relations and other public-sector systems. Kaneko argues that enhancing equity and socializing many of these risks more broadly will facilitate the country's industrial transformation. This is because, he insists, the holes in the current safety net impede labour mobility, restrict consumers' willingness to spend, and hinder the overall political economy's capacity to adjust to changing needs and opportunities.

The gargantuan public debt built up under the current political order has not brought the high interest rates that would have resulted if domestic savings were as scarce as in, say, the United States. But as Kaneko and a host of other public finance specialists have warned, the risk of Japan's falling into a 'debt trap' increases with each weighty dollop of deficit spending. A debt trap refers to the grave situation that occurs when a country is forced to issue new bonds in order to finance interest payments on past debt. Borrowing money to pay for past borrowing, especially when much of it was spent on unproductive assets, means deep trouble. As the state prints more and more of its increasingly dubious currency, the result is often hyperinflation and the politically destabilizing impoverishment of the middle classes.

Disposition of Japan's bad loan problem requires the use of public funds (to rebuild the banks' reserves) and the rescheduling of debt for firms in the grey zone. But in tandem, there must be strict inspection standards as well as a thorough investigation of bankers' responsibility for the financial debacles of the 1990s. Kaneko warns that fixing the bad loan problem will only serve to prevent a collapse of the financial system: it will not restart Japan's economy and could lead to a serious crisis of its own making if not coupled with stimulative measures.

Some observers, wanting the state to back off as much as possible, appear confident that tax cuts would provide sufficient stimulus. But Kaneko argues that the emphasis should be on spending. Yet rather than expand the deficit and pump more large-scale public works into the economy, what is required is a full-scale reconstruction of the flow of public finances and a concomitant shift to small-scale projects and welfare-related services (especially directed towards the needs of the environment, the aged and the handicapped). In particular, because over two-thirds of Japanese public spending is done at the local level, fiscal decentralization features prominently in Kaneko's reform model.

Distinctively Japanese measures for a distinctively Japanese mess? Perhaps. But given the similarities in causes, perhaps the solutions will have to be similar in many ways. Japan had yet to implement a successful solution when this current mess that started in the US hit them.

Just when Japan finally seemed able to export its way out of its mess, world economic activity began slowing down. Now that everyone the world over has the same problem, no country can expect another to solve its own mess. Everyone will have to start with their own domestic market.

No comments: